October 2011 RFF DP 11-46 DISCUSSION 2011 RFF DP 11 ... costâ€effective abatement, deliver powerful innovation incentives, and ameliorate rather than ... focused on cutting CO2

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    October 2011 RFF DP 11-46

    The Promise and Problems of Pricing Carbon: Theory and Experience

    Joseph E . Al dy and Rober t N . St avi ns

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  • THEPROMISEANDPROBLEMSOFPRICINGCARBON:

    THEORYANDEXPERIENCE

    JosephE.Aldy

    and

    RobertN.Stavins

    ForaSpecialIssueof

    TheJournalofEnvironmentandDevelopment

    EditedbyThomasSternerandMariaDamon

    October27,2011

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    ThePromiseandProblemsofPricingCarbon:TheoryandExperience

    JosephE.AldyandRobertN.Stavins

    ABSTRACT

    Because of the global commons nature of climate change, international cooperationamongnationswill likelybenecessary formeaningfulactionattheglobal level. Atthesametime, itwill inevitablybeup to theactionsof sovereignnations toput inplacepolicies thatbringaboutmeaningfulreductions intheemissionsofgreenhousegases. Duetotheubiquityanddiversityofemissionsofgreenhousegases inmosteconomies,aswellasthevariation inabatement costs among individual sources, conventional environmental policy approaches,suchasuniformtechnologyandperformancestandards,areunlikelytobesufficienttothetask.Therefore, attention has increasingly turned to marketbased instruments in the form ofcarbonpricingmechanisms.Weexaminetheopportunitiesandchallengesassociatedwiththemajor options for carbon pricing: carbon taxes, capandtrade, emission reduction credits,cleanenergystandards,andfossilfuelsubsidyreductions.KeyWords: global climate change,marketbased instruments, carbonpricing, carbon taxes,capandtrade,emissionreductioncredits,energysubsidies,cleanenergystandardsJELClassificationCodes:Q540,Q580,Q400,Q480

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    ThePromiseandProblemsofPricingCarbon:TheoryandExperienceJosephE.AldyandRobertN.Stavins1

    ForaSpecialIssueofTheJournalofEnvironmentandDevelopment

    EditedbyThomasSternerandMariaDamonIntroduction

    In a modern economy, nearly all aspects of economic activity affect greenhouse gas in

    particular, carbon dioxide (CO2) emissions, and hence the global climate. To be effective, climatechangepolicymustaffectdecisionsregardingtheseactivities. Thiscanbedone inoneofthreeways:(1) mandate businesses and individuals to change their behavior regarding technology choice andemissions; (2) subsidize businesses and individuals to invest in and use loweremitting goods andservices;or(3)pricethegreenhousegasexternality,sothatdecisionstakeaccountofthisexternalcost.

    By internalizing the externalities associatedwith CO2 emissions, carbon pricing can promote

    costeffectiveabatement,deliverpowerfulinnovationincentives,andameliorateratherthanexacerbategovernmentfiscalproblems.BypricingCO2emissions(or,equivalently,bypricingthecarboncontentofthe three fossil fuels coal, petroleum, and natural gas), governments defer to private firms andindividualstofindandexploitthelowestcostwaystoreduceemissionsandinvestinthedevelopmentof new technologies, processes, and ideas that could furthermitigate emissions. A range of policyinstruments can facilitate carbon pricing, including carbon taxes, capandtrade, emission reductioncredits,cleanenergystandards,andfossilfuelsubsidyreduction.

    Someof these instrumentshavebeenusedwith success inotherenvironmentaldomains,as

    wellasforpricingCO2emissions. TheU.S.sulfurdioxide (SO2)capandtradeprogramcutU.S.powerplantSO2emissionsmorethan50percentafter1990,andresultedincompliancecostsonehalfofwhattheywouldhavebeenunderconventionalregulatorymandates(Carlson,Burtaw,Cropper,andPalmer,2000).ThesuccessoftheSO2allowancetradingprogrammotivatedthedesignandimplementationoftheEuropeanUnionsEmissionTradingScheme (EUETS), theworlds largest capandtradeprogram,focused on cutting CO2 emissions from power plants and largemanufacturing facilities throughoutEurope(EllermanandBuchner,2007). TheU.S.leadphasedownofgasolineinthe1980s,byreducingthe lead contentper gallonof fuel, served as an early,effectiveexampleof a tradableperformancestandard(Stavins,2003). Thesepositiveexperiencesprovidemotivationforconsideringmarketbasedinstrumentsaspotentialapproachestomitigatinggreenhousegasemissions.ClimateChangePolicyInstrumentsfortheRegional,National,orSubNationalLevel We consider fivegenericpolicy instruments that could conceivablybeemployedby regional,national,oreven subnationalgovernments forcarbonpricing, includingcarbon taxes,capandtrade,emissionreductioncredits,cleanenergystandards,andfossilfuelsubsidyreduction.First,however,weexaminethepossibilityofrelyingonconventionalenvironmentalpolicyapproaches,namelycommand

    1 Aldy isAssistant Professor of Public Policy,Harvard Kennedy School;Nonresident Fellow, Resources for theFuture;andFacultyResearchFellow,NationalBureauofEconomicResearch. Stavins isAlbertPrattProfessorofBusinessandGovernment,HarvardKennedySchool;University Fellow,Resources for theFuture;andResearchAssociate,NationalBureauofEconomicResearch.

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    andcontrol instruments,whichhavedominatedenvironmentalpolicy invirtuallyallcountriesoverthepastfourdecades.CommandandControlRegulations

    Conventional approaches to environmental policy employ uniform standards to protect

    environmentalquality.Suchcommandandcontrolregulatorystandardsareeithertechnologybasedorperformancebased. Technologybased standards typically require the use of specified equipment,processes,orprocedures.Intheclimatepolicycontext,thesecouldrequirefirmstouseparticulartypesofenergyefficientmotors,combustionprocesses,orlandfillgascollectiontechnologies.

    Performancebased standards aremore flexible than technologybased standards, specifying

    allowablelevelsofpollutantemissionsorallowableemissionrates,butleavingthespecificmethodsofachieving those levels up to regulated entities. Examples of uniform performance standards forgreenhousegasabatementwouldincludemaximumallowablelevelsofCO2emissionsfromcombustion(for example, the gramsofCO2permile requirement for cars and lightduty vehicles recentlypromulgated aspartofU.S. tailpipe emission standards) andmaximum levelsofmethane emissionsfromlandfills.

    Uniform technologyandperformance standards can inprinciplebeeffective inachieving

    some environmental purposes. But, given the ubiquitous nature of greenhouse gas emissions fromdiversesources inaneconomy, it isunlikelythattechnologyorordinaryperformancestandardscouldformthecenterpieceofameaningfulclimatepolicy.

    Furthermore,thesecommandandcontrolmechanisms lead tononcosteffectiveoutcomes in

    whichsomefirmsuseundulyexpensivemeanstocontrolpollution. Sinceperformancestandardsgivefirms some flexibility in how they comply, performancebased standardswill generally bemore costeffectivethantechnologybasedstandards,butneithertendstoachievethecosteffectivesolution.

    Beyond considerationsof static costeffectiveness, conventional standardswouldnotprovide

    dynamic incentives for thedevelopment,adoptionanddiffusionofenvironmentallyandeconomicallysuperior control technologies. Oncea firm satisfiesaperformance standard, ithas little incentive todeveloporadoptcleanertechnology.Regulatedfirmsmayfearthatiftheyadoptasuperiortechnology,the government may tighten the performance standard. Technology standards are worse thanperformance standards in inhibiting innovation since, by their very nature, they constrain thetechnologicalchoicesavailable. The substantiallyhighercostofa standardsbasedpolicymayundermine support for suchanapproach, and securing political support may require a weakening of standards and hence lowerenvironmentalbenefits.2 The key limitations of commandandcontrol regulations can be avoided through the use ofmarketbased policy instruments. In the context of climate change, this essentiallymeans carbonpricing.

    2 However, in special cases where emissionmonitoring and enforcement is particularly costly such as formethaneemissionsinagricultureastandardsbasedapproachmaybeappropriate.

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    CarbonTaxes

    Inprinciple,thesimplestapproachtocarbonpricingwouldbethroughgovernment impositionof a carbon tax (Metcalf,2007). The government could set a tax in termsofdollarsper tonofCO2emissions (orCO2equivalentongreenhousegasemissions)bysourcescoveredby the tax,ormorelikelyataxonthecarboncontentofthethreefossilfuels(coal,petroleum,andnaturalgas)astheyenter theeconomy. Tobecosteffective, sucha taxwouldcoverall sources,and tobeefficient, thecarbon price would be set equal to the marginal benefits of emission reduction, represented byestimatesofthesocialcostofcarbon(InteragencyWorkingGrouponSocialCostofCarbon,2010).Overtime,anefficientcarbontaxwould increasetoreflectthefactthatasmoregreenhousegasemissionsaccumulate in the atmosphere, the greater is the incremental damage from onemore ton of CO2.Imposingacarbon taxwouldprovidecertaintyabout themarginalcostofcompliance,which reducesuncertaintyaboutreturnsto investmentdecisions,butwould leaveuncertaineconomywideemissionlevels(Weitzman,1974).

    Thegovernmentcouldapplythecarbontaxatavarietyofpoints intheproductcycleoffossil

    fuels, from fossil fuel suppliers based on the carbon content of fuel sales (upstreamtaxation/regulation) to final emitters at the point of energy generation (downstreamtaxation/regulation). Under an upstream approach, refineries and importers of petroleum productswouldpaya taxbasedon thecarboncontentof theirgasoline,diesel fuel,orheatingoil. Coalmineoperatorswould pay a tax reflecting the carbon content of the tons extracted at theminemouth.Naturalgascompanieswouldpayataxreflectingthecarboncontentofthegastheybringtosurfaceatthewellheador importviapipelinesor liquefiednaturalgas (LNG) terminals. Focusingonthecarboncontentoffuelswouldenablethepolicytocaptureabout98%ofU.S.CO2emissions,forexample,witharelativelysmallnumberofcoveredfirmsontheorderofafewthousandasopposedtothehundredsofmillionsofsmokestac